FTX: the rise and downfall of the crypto exchange

March 9, 2024 Kathleen Xie

By Samarth Singh

Shortly after 6:00 PM, December 12th 2022, Sam Bankman-Fried was arrested in the Bahamas. After being held in prison for ten days, he consented to be extradited to the USA, where he would face charges of multiple frauds. However, just one year ago, he was the richest individual under 30 years with a net worth of $22.5 billion.

It’s 2013. Meet Sam Bankman-Fried (also called SBF), an MIT graduate who interned at Jane Street Capital, a quantitative trading firm. Jane Street is extremely reputed and elite, and very difficult to get into. Undoubtedly, SBF is smart; he is known to love puzzles and math and takes many risks. Four years later, he created a hedge fund called Alameda Research. A hedge fund borrows money from investors and then invests it in hopes of better returns. This is usually very risky but can also have high returns. SBF said the company was called a “research” because banks wouldn’t give a bank account to a company with a name indicating crypto trade. Alameda Research took advantage of the difference in prices between cryptocurrency prices in different markets, which, in financial terms, is called arbitrage. So, for example, if one cryptocurrency coin is worth one dollar in America but two dollars in Japan, Alameda Research would buy that coin in America and sell it in Japan, earning a profit of one dollar.

SBF started with money borrowed from his friends and family. However, doing arbitrage wasn’t necessarily easy. The thing about Alameda Research is that they did earn profits. By the end of 2018, they had earned between $10 million and $30 million. In 2019, SBF and his team moved from Berkeley to Hong Kong, since the market for cryptos was much friendlier and interesting over there. He was also able to connect to multiple investors and venture capitalists. Venture capitalists invest money in companies which might have high growth potential in exchange for equity. If the company grows, it's a profitable investment, but if it doesn’t, the money doesn’t have any returns.

Venture Capitalist Alex Pack invested in Alameda Research. However, one day, he noticed that SBF’s trade was making losses. When asked about it, SBF said that he had been working on a Cryptocurrency Exchange, and that’s why he couldn’t focus on the trades. However, he had used the money and resources invested into Alameda Research, and this wasn’t exactly right, since the investors had invested their money into Alameda Research, but it was being used to create another company in which the investors did not have any information about or any equity stake. Even more, the investor's money put into Alameda was becoming a loss since SBF and his team weren’t focused on the arbitrage. Alex Pack said explaining the investor's concern to SBF was “like explaining business ethics 101 to a baby,” in a documentary made by Bloomberg Originals.

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That year, in 2019, he and Gary Wang founded FTX (short for “Futures Exchange”). It was a centralized cryptocurrency exchange, a platform where one can buy and sell cryptos. It acts somewhat like a broker and usually has low fees and high security.

Luckily for FTX, their entry into the market was perfect, as the cryptocurrency market was getting bullish. In 2020, cryptocurrency grew by a lot. The price of Bitcoin increased by 300%, mainly due to the low interest rates charged. This also meant that it was much easier for SBF to convince investors to invest in them. Many investment institutions such as BlackRock, SoftBank Group and Sequoia Capital invested in FTX. Unsurprisingly, FTX’s value increased by 77% to $32 billion in just 6 months.

With this crypto boom, however, regulations also became stricter. Therefore, FTX and Alameda shifted to the Bahamas.

No wonder, FTX spent a lot on marketing. Not all figures have been made public, but they committed at least $375 million in sports (excluding the fees given to any professional athletes). Whether it was rugby, racing, baseball or even naming rights to an arena in Miami, FTX entered everywhere. They were able to have famous figures such as Stephen Curry, Lewis Hamilton, Tom Brady and Kevin O’Leary endorse them. This generated trust and encouraged people who do not know cryptocurrency to use FTX. FTX’s Super Bowl ad campaign said that throughout history, there have been haters, but cryptocurrency was the next big thing.

To many, SBF wasn’t the conventional cryptocurrency enthusiast. He was successfully able to create this narrative where he was a minimalist, innovative, unconventional yet truthful person who wanted to reform cryptocurrency exchanges.

However, for many experts and crypto traders, their view of SBF was much different from what the mainstream media thought. Many said that cryptocurrency trading wasn’t as easy as it was shown, and it had high risks involved, or stated that the pace at which FTX was growing wasn’t fit for its team size, or that Alameda could use data FTX has to make profitable trades. Others also disagree with how SBF was portrayed, stating that SBF's spending was unreasonable, with a $35 million penthouse in the Bahamas and frequent office parties.

Cryptocurrency wouldn’t rise with just media or marketing. Policies had to be made (or changed) to make it legal in many countries. Large investments were only possible when crypto became regulated. For this, SBF became even more involved in Politics and Policy Making. As per a report by Reuters, he donated more than $100 million to political campaigns in the US. However, political influence alone won’t cut it. They required the consent of the CFTC (Commodity Futures Trading Commission), which is an independent federal agency that regulates derivative markets, including future contracts, options and swaps in the United States (Investopedia, 2021). Getting the consent of an independent organization wasn’t going to be easy even if one has political influence.

One of the other major players in the industry was Binance, founded by Changpeng Zhao (he also invested 20% in FTX). While neither of them acknowledged it, many say that they were competitors in the field, and whoever could enter the markets first after crypto was regulated would stand to gain.

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Many cryptocurrency exchanges have their own cryptocurrency tokens. Crypto tokens are different from cryptocurrency. While cryptocurrency intends to be a mode of payment or exchange, cryptocurrency tokens are used to raise crowdfunding through an ICO, or Initial Coin Offering. If people feel that the exchange will grow, they can invest in the token either to facilitate transactions or to hold an equity stake in a company.

However, unlike cryptocurrency coins, tokens are centralized and in this case, FTX could mint as many tokens as they wished. FTX said that they would use approximately 33% of their revenue to buy back their FTT tokens. This made people think that the exchange was growing and their tokens would be bought back at a higher price, thus giving a profit.

Luna token was a famous token, giving high rates of return (around 20%). It was connected to terraUSD (also called UST). UST was a stablecoin, but it was not fiat-backed, but instead backed by its sister token Luna. For example, if Luna’s price is $100, then they could trade it for 100 UST. So for UST to retain its peg, it had to be changed for $1 worth of Luna tokens (Forbes, 2022). The Anchor Protocol was a decentralized money market built on the Terra blockchain. This algorithm gave high returns, but it did so not by growing, but by paying the previous investors with the money received in later investments. Many thought of it as “an obvious Ponzi scheme”. A Ponzi scheme is a form of fraud which makes later investors pay for the investment of previous investors, thus giving high returns, but the scheme collapses when funding dries up and it no longer can give any returns.

A crypto hedge fund called Three Arrows Capital was one of the most respected and profitable hedge funds operating in the space. They invested in multiple coins and tokens. A major chunk of their investment was the Luna Token, with $200 million invested in it.

However, the Luna token collapsed in May 2022. Millions of UST coins were immediately liquidated. This could have been due to rising interest rates or a malicious attack on the blockchain technology. Once so much of the UST was liquidated, the stablecoin started to decrease in value with respect to Luna (since UST was pegged to Luna). In a frenzy, more people sold UST, and more Luna tokens were minted (since again, UST was pegged to Luna). The token soon became worthless since there was too much of it in the market.

Three Arrows Capital owed a lot to investors, and they couldn’t pay their debts back. In July 2022, Three Arrows Capital filed for Chapter 15 Bankruptcy. Because of this major collapse (of a major hedge fund), lenders asked hedge funds to return their money, to check if the fund had the money invested. Alameda Research was one of the funds that was asked to return the money invested.

Alameda owed billions of dollars; however, it didn’t have the money to pay it back. The leadership of FTX (the same people who chaired Alameda Research as well) had two choices, either to declare Alameda bankrupt or to use FTX Customer Funds to pay the loans back. Basically, they took a loan from FTX with their collateral as FTT tokens (Bloomberg Originals, 2023). They chose the latter. SBF acknowledged that a meeting took place to discuss the matter, but said that it didn’t matter to him then.

Instead of being very conservative with investments, SBF did the opposite. He invested $240 million in Blockfi, a digital asset lender. Many began to call him the JP Morgan of crypto. Some executives in FTX started to leave. The FTX US President, Brett Harrison, and Sam Trabucco, co-CEO of Alameda Research resigned.

Many events happen simultaneously. SBF was still pushing for regulations in multiple markets. This is where Changpeng Zhao’s 20% stake started to be felt. Most regulators asked for details of who was in the company, and being a 20% stakeholder, Zhao had to disclose his details, but he refused to do so. Many allege that Zhao’s stake in FTX was just to slow its progress down, as it would be in this case. Since Zhao was blocking FTX’s progress, his shares had to be bought back. SBF offered a ludicrously high return for Zhao’s investment, closing the deal at $2.1 billion. $550 million of it was paid in FTT tokens, which meant that Zhao now owned (and could sell) many FTT tokens.

Coindesk published a report stating that most of Alameda Research’s assets were FTX tokens. This raised suspicions about the credibility of FTX. Soon, Zhao tweeted that because of what had happened, he is looking forward to liquidating the FTT tokens Binance has. As people lost trust in FTX, they started to withdraw FTT tokens (the withdrawals were worth billions). However, FTX couldn’t return their money, and at one point, disallowed people to withdraw any FTT tokens. Following this, news reports flooded the media, stating that Binance would like to buy FTX. As per Zhao, he found problems with FTX’s finances and backed out of the deal, that is, he wasn’t buying FTX anymore.

The reason FTX couldn’t return the money was that Alameda Research owed FTX around $10 billion from customer funds, and Alameda Research basically had no way to return the money. Now, customers asked for their money back, and FTX didn’t have it, and thus, the entire liquidity crisis, Zhao’s offer and then his backing out.

FTX filed for bankruptcy in November 2022.

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Months of marketing and work go in vain in just about a week. SBF is no longer the “saviour” of the industry, but instead a villain who decreased people’s trust in cryptocurrency. The price of Bitcoin dropped from $67,000 in November 2021 to $16,000 in November 2022. Investors lost a lot of money, and many people, if not families, were affected.

Most would expect that after such a big failure, SBF would lay low for at least a while. He did the opposite, instead choosing to be interviewed by multiple media outlets. His lawyers did not advise him to do so but he said that “they don’t understand the broader context of the world”. In one particular interview on Twitter Spaces, SBF was asked “Customer funds were being sent to Alameda Research, can you help me understand how is that not wire fraud?”. SBF refrained from answering that question, and within a few hours, he was arrested in the Bahamas.

With this, we go back to SBF’s arrest and the charges against him. He pleaded not guilty but was found guilty of multiple frauds. It is said that he could face up to 115 years in prison. However, recent developments (as of 3rd March 2024), such as returning 90% of recovered assets (many differ on that as well), make it more unpredictable. SBF’s lawyers suggest only a 5-6 year prison sentence. The final sentence will be given on 28th March 2024.

FTX’s rise and downfall is a very interesting story, and there’s a lot to be learned from it.

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